The expression “flying blind” dates back to World War II when pilots who couldn’t see the horizon because of darkness or clouds were forced to rely on their rudimentary navigational instruments. Many became spatially disoriented (SD), experienced vertigo, and often crashed. Even today IFR pilots (instrument flight rules) are not immune from SD. The U.S. Air Force investigated 633 crashes between 1980 and 1989 and SD was identified in 13% of cases as a contributing cause. Non-instrument-rated pilots (VFR or visual flight rules) have a life expectancy of less than three minutes when encountering weather conditions that require navigation instrumentation.
How Institutional Investors Fly
I recently read a purportedly groundbreaking scholarly study on methodologies and biases that impact financial decision-making of institutional investors. Until recently, the writers claim, most of such research has focused on retail investors.
The study, “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors” (December 2018), dissected an impressively large database. Though buried in the text, the following qualifier caught my attention: “Given that the portfolio managers in our sample tend to hold limited cash positions and are not generally permitted to use leverage, the primary mechanism for raising money to purchase new assets is selling existing ones.”
The performance of most assets under the supervision of professionals is measured on a relative, keep-up-with-the-Joneses, basis. The return of the manager is compared to some benchmark, usually an index like the S&P 500. The pressure to match that metric encourages high equity allocations and minimal cash. Further, the failure of many to keep up with their benchmark has given rise to the ubiquitous index funds which essentially do the same job with much lower fees.
While reflecting on this dynamic, my mind kept returning to pilots flying blind. Professional pilots don’t make money for the airlines when they’re not airborne. Likewise, institutional investors must stay fully invested if they expect to keep pace with their benchmark. Regardless of their sophistication, inclimate weather can be a major liability.
Pilots fly in a world of absolutes, the most obvious and undeniable of which is gravity. While often downplayed, remember that gravity also exists in the world of investments. When it exerts its force is unclear; most often years pass between unpredictable episodes. To what extent a soft or hard landing will occur is so vague that index trackers routinely forget gravity’s inevitable effects. These relative-return investors avoid the cognitive dissonance implicit in perpetually rising prices that chafe at managers with a deeper sense of financial history. Most managers default into a disaster myopia that ignores attendant risk, a luxury that pilots, who fly in a world where risks are absolute, cannot abide.
2009 Was Merely Turbulence
This myopic mindset is a pernicious threat to global financial stability and, ultimately, to the financial well-being of millions of passive, relative-return investors. A crash landing of relative return investing has not occurred since the financial crisis of 2008-09. In that frightening episode, however, the worst of the bear market was quite contained. Between mid-September 2008 and mid-March 2009, the market swooned almost 50%. But by September 2009, a mere six months later, the S&P 500 had already regained two-thirds of its value.
The real pain was felt on the ground. What stockholders suffered—with the S&P 500 as proxy—was insignificant compared to non-shareholding workers who lost their livelihoods and, for many, their homes. The rebound in the unemployment rate was glacial by comparison. After peaking at 10% in December 2009, it didn’t return to pre-recession levels until mid-2017. Today aside, relative-return investors haven’t flown dangerous skies since the dot.com bust, which lasted from 2000 to 2003.
The Emergence Of Relative-Return
By way of background, the emergence of relative-return investing dates back to “Mayday” in Wall Street parlance (May 1, 1975), when the New York Stock Exchange determined that commissions should be negotiable, not fixed as they had been forever. In response, opportunistic discount brokers like Charles Schwab grabbed market share from less nimble traditional brokerages. Shortly thereafter, capital gains taxes began their migration south, from 35% to 15%.[1]
Coupled with drastically reduced transaction costs, annual share turnover soared from 20% in 1975 to 200% by 2000.
Old-school buy-and-hold investing by individuals who stuffed their physical stock certificates into safety-deposit boxes faded from use like the typewriter in the digital age.
The increased flexibility to reposition a portfolio allowed the exploding number of mutual funds in the wake of the newly created 401(k) to more closely mimic index returns. This was the real acceleration of relative-return investing. Index funds, ETFs (exchanged-traded funds), and similar products were soon proliferating for public use.
The Ascension Of Mutual Funds
The bar chart below makes abundantly clear, nature abhors a vacuum. As the bull market of the 1980s was getting under way, a thriving mutual fund industry sprang up to give Main Street savers a way of participating in the prosperity. Investors climbed aboard in substantial numbers only late in the 1980–2000 cycle. This phenomenon was dependent on the advent of the 401(k) in 1978, generally rising stock prices, the increasing dispersion of the front-end load on mutual funds to more hidden fees, and increased comfort among retail investors with indirect ownership of equities.
The share of households owning mutual funds plateaued in 2000.
Mutual fund investors have always tended to view the future through the rear-view mirror. Specifically, there’s a high correlation between recent stock market performance and household-equity ownership as retail investors climb aboard when times are good. The percentage of household assets in equity funds collapsed from 32.9% in 1999 to 22% in 2003 following the decline during the dot.com bust. This was partially due to falling stock prices and partly to disaffection.
Unnerved by the two bear markets since 2000 and the overall sub-par performance of the S&P 500, historically speaking, it’s not surprising that retail investors are less than enamored with equities. Whether due to decreased financial capacity or diminished confidence in the markets, retail investors hold less total stock today than in 2007. Their reduced participation in this bull market is clearly a contributing factor to widening wealth disparity.
Fortunately for the markets and, indirectly, for mutual fund investors, corporate buyback programs have at least partially filled the buyer’s gap. Given the sensitivity of both mutual fund investors and corporations to declining stock prices, a bear market now could be particularly devastating.
The Cloudy Horizon
Metaphorically, the markets and the economy, in all its facets, are thick with opacity, making all investors susceptible to spatial disorientation. Just because the pull of gravity in the capital markets is imprecise, it’s a terrible mistake to assume it doesn’t exist. Much of the investment world is flying blind. To tell your airline (employer) that you’re not going to fly (invest) until conditions improve is to invite a pink slip. For most in the investment profession, however, preservation of one’s livelihood takes precedence over loyalty to clients.
Circling back to “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors,” we found the abstract to be so narrow as to be essentially irrelevant. Though the authors mostly hypothesize changes to institutional management, their proposals deserve a hearing.
First, they argue, institutional investors should devote fewer “attentional resources” to new ideas. To be sure, there’s something fresh, exciting, and hopeful about a new idea. Even though an old idea may be beguilingly cheap, it simply doesn’t elicit the same response. They also highlight a current tendency to sell historically volatile stocks. Assets with extreme returns, positive or negative, are 50% more likely to be sold than those with middling performance histories. They conclude that such a tendency “appears to be a mistake and is linked empirically with substantial overall underperformance in selling!”
What, in our opinion, they overlooked is, admittedly, an anachronism in today’s relative-return world. The antonym for relative is absolute. Absolute-return investors, almost all of whom are of the value persuasion, abhor big “drawdowns”—the peak-to-trough decline in a portfolio, usually during bear markets. Two points are worth noting:
- First, significant drawdowns wreak havoc with long-term compounded returns and, no less importantly, investors are prone to become irrational (a.k.a. panic) at the worst possible time. One of our least talked-about but most important responsibilities as managers is to avoid putting clients in that wealth-threatening position.
- Second, absolute-return investors suffer from acrophobia, becoming more and more anxious the higher valuations go. Given the metrics we use to measure value, it should be easy to understand why we are nearly apoplectic.
For absolute-return investors, the principal downside to refusing to fly in threatening conditions—in holding cash in lieu of equities—is career risk. Someday the tide will turn, as it invariably does, and in the eyes of the world we will be transformed from toad to prince. Knowing that neither moniker fits, just like today, it will be business as usual, as neither fear nor greed will be part of the investment decision-making process.
[1] https://www.fool.com/retirement/2017/02/11/a-95-year-history-of-maximum-capital-gains-tax-rat.aspx